The Accounting Equation

The mathematical principle for double entry bookkeeping is the Accounting Equation.

If about now you want to run a mile because math isn’t your thing... don’t worry! You don’t have to be a mathematical genius to do bookkeeping. Bookkeeping is about organising numbers into categories which are then totalled. You can use a calculator for that...!


...and the Accounting Equation is about classifying the values from business transactions into separate bookkeeping accounts.

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Business transactions are activities that have an effect on what the business owns, what it owes, and the ownership.

The trick is simply to learn into which account the value from each transaction should be assigned. The following section will help you figure it out.

Here is the Accounting Equation:-

Assets = Liabilities + Equity

You can memorise it by shortening it to ALE.

A assets ............ are what the business owns.

L liabilities ......... are what the business owes.

E equity .. ......... represents the ownership of the business.

Lets break it down....

Equity

When starting a business the owner (also called proprietor) introduces assets such as cash and office equipment used within the business to generate more assets... such as cash and office equipment!

Equity is the ownership of the assets of the business by the proprietor.

So the start of the accounting equation is :

assets = equity


Accounting Equatio

If Mr Grey contributes $600 in cash to his business so that it can operate, the entry in the accounting books would change both the asset account and the equity account, increasing each by $600. The asset account is the business part and the equity account is Mr Grey’s part.

Mr Grey may at any time introduce more assets in which case the asset and equity accounts will equally increase, thus maintaining the equation balance.

Mr Grey may also chose to withdraw an asset (such as taking out cash for personal use) in which case the two accounts will decrease equally. Assets withdrawn for personal use by the owner are called drawings.

Another name for equity is capital. So if you see either of these words anywhere there is no need to be confused... they mean the same thing.

The true equity value is calculated after liabilities are factored in.

Liabilities

The dictionary definition of liable is ‘responsible by law: legally answerable’ (Oxford University Press).

A liability is a financial obligation. The business is legally responsible for the financial obligation.

The obligation could be:-

  • Money owed to suppliers/vendors for goods and services purchased (accounts payable).
  • A loan that the business is paying back. A loan that takes more than a year to pay back is called a long term liability.


Assets

These are items that have a money value and belong to the business. What items can a business own? There are five common divisions:-

Current Assets

        Cash - in the cash box or the bank
        Money owed to the business (accounts receivable) by its customers
        Short term investments such as a term deposit that matures within a year

Fixed Assets

These are all tangible assets that have a physical form and can also be grouped under the heading plant:-

        Workshop equipment
        Buildings
        Land
        Vehicles
        Office equipment
        Furniture and fittings

Fixed assets are used in the operation of the business for several years. 


Inventory

This represents the items in stock that you buy and sell. 


Long Term Investments

    Typically money belonging to the business that is not used in the running of the business but is invested elsewhere, and is not expected to be converted to cash within a year. For example:-

    Stocks
    Bonds
    Investment in another business

Intangible Assets

These assets have a value to the owner but are not a physical or touchable item. They include:      

      Trademarks
      Goodwill
      Copyrights
      Patents

Revenue and Expenses

There are two other important bookkeeping accounts that are not represented in the accounting equation because they are temporary accounts:-

  • the revenue account
  • the expenses account

At the end of a financial year the difference between the revenue and expenses will be assigned to the equity account. The difference might be a profit or a loss.

The revenue and expense accounts will then be cleared with a special adjustment to start fresh with no balances in the new financial year, which is why they are called temporary accounts.


The equity, assets and liability accounts are not cleared at the end of a financial year and so are called permanent accounts. However, the equity account will change as a result of the special adjustment which moves the profit or loss into it.

The accounting equation is the basis upon which the financial condition of a business is presented through means of a bookkeeping balance sheet. The accounting equation is a fundamental part of business bookkeeping.


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Accounting Equation




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